Getting the Best out of Passive and Active Investing

Inflows into passive investments, particularly offshore, have been significant following extensive media coverage and analysis that questions the ability of the majority of active fund managers to outperform the major indices over time. Should we be switching all our investments into passive strategies? This would be cheaper, easier to administer and could arguably provide better performance than a great many actively managed funds.

By way of background:

In passive investing, people buy into an index fund instead of purchasing individual shares. When you invest, you are buying all the stocks in the index on a pro rata basis. When the market goes up, so too does the fund. But in a declining market, there is no cushion, and the fund will decline with it. As an investor, there is no downside protection in the fund, other than selling out at potentially the wrong time, which means that investors in this strategy need to be mature and calm in turbulent times.

In short: passive investing aims to maximise returns over the long run by keeping the amount of buying and selling to a minimum. The idea is to avoid the fees and the drag on performance that potentially occur from frequent trading.

An index fund is created by looking at the weightings of each stock in the market. For example, Apple comprises 4.9% and Boeing 7.7% of the Dow Jones Index in the US. Naspers is 22% of the JSE in SA.

Active investing is very different. There are mainly two forms of active fund management: Growth management and Value management.

A Growth manager aims to hold more stocks that are trending up than the index and sell them at the right time. They are buying on momentum and believe they can time the moment to get in and out of stocks.

A Value manager looks for stocks that the market has under-priced for whatever reason. This means that when the market eventually realises this, other investors will drive the price up, at which stage the value manager can sell for a profit. In addition, in a declining market, the price of these “value” shares should decline by less than the more popular, more expensive shares at the time. Value managers believe they make most of their extra returns in falling rather than in growth markets.

In both cases, in a declining market, an active manager has the ability to increase exposure to cash and defensive assets to provide some downside protection, in contrast to passive funds which will continue to track the market.

Look what’s happening in the US

The use of passive funds in the US is reaching unprecedented levels. About US$1 trillion of assets has been taken out of actively managed funds and invested in low-cost passive funds, with Vanguard and Blackrock being the two biggest globally. This is partly in reaction to the global financial crisis in 2008-9 and how Wall Street firms treated their clients, and also due to a large number of active funds underperforming the indices.

Some perspective
The US has now been in a bull market since 2009 – effectively an eight-year uninterrupted bull market with relatively weak fundamentals, manufactured by the Fed keeping interest rates at all-time lows while inflation remains low.

What has always been known about passive investments is that when the market is escalating, it is very hard for active managers to outperform them. An eight-year market run makes indexation look appealing. If an investment does well, it then attracts more investors. These inflows are then utilised to buy more of the index, which drives up valuations further. It does eventually run the risk of creating a bubble, given that assets are bought blindly regardless of whether or not they are overpriced.

Active managers say with glee that they love indexation investing as it makes their jobs easier. When they want to offload a stock that has increased in price and they believe is now overpriced, there is an automatic buyer. With indexation, the more a stock’s price goes up relative to the index the more of it is bought at a more expensive price. Essentially you are buying more and more of something that is becoming more and more expensive, which is in direct contrast to active value investing.

The Veritas Wealth approach

As independent advisers, our concern is not whether we use active or passive managers. What we are concerned with is helping our clients achieve their goals by targeting a realistic, risk-adjusted return after costs and taxes. We want to do this as efficiently and effectively as possible, and if this means using passive managers then so be it.

What we love about passive investing is that it has put the cat among the pigeons in the active asset management arena. It has helped to put price pressure on the industry (as seen in some other countries) and this reduction in fees has only just begun in South Africa. In the next year or so, new legislation will come into effect, namely the Retail Distribution Review (RDR) which proposes substantive reforms to the regulatory framework for financial advice and for distribution of financial products to customers. This will put further downward pressure on costs.

As an independent adviser, Veritas has a constant stream of sales agents from both active and passive managers stating their convincing arguments for both sides. We prefer to adopt a more rational approach, one where we can use a combination of both strategies to achieve a better risk-adjusted return over the long term. The benefits for clients is that it brings the overall cost down and puts price pressure on the active managers, which ultimately helps us to achieve the targeted return more easily. Given South Africa’s relatively small market, passive investing tends to be more effective in more efficient overseas markets. As a result, we have used it more in our offshore portfolios. We also think the bias towards Value managers is a better blend with passive investments.

Finally, we also know as planners that the most important decision we make for our clients is the asset allocation decision we make when constructing the portfolio and the diversification we include in that construction.

Many financial planners may back either an active or passive strategy exclusively. We don’t agree with this view, but will continue to watch market developments and wait to see what happens through the cycles. What we know for certain is that markets will fall at some point and passive investors may sell at the wrong time. Investors lacking sound advice will exacerbate the correction, which would also impact negatively on the active managers. If, of course, these nervous investors stay the course, they will recover their “losses”, with active managers getting a head start at the beginning of another bull run!

Here is an illustration of the make-up of the Dow Jones index in the US Top 10 holdings

1 Comment

Andre Du Toit
on September 28, 2017 at 5:13 pm

In a Core (70% Index-tracking funds) and Satellite (30% Actively managed funds) approach an investor tries to combined above mentioned strategies in a strategic manner. Warren Buffet for example is a big supporter of passively managed funds. I believe BOTH strategies are important and each approach has its own specific merits is a well diversified portfolio.